Because stock options are an extremely complicated topic when it comes to division in divorce actions, this article is just an overview of the basics. When a stock option is offered to an employee, it is called a grant. An option is exercised when the employee purchases the stock under the terms of the option granted by the employer.
How Stock Options Work
An employer grants a stock option to an employee by giving them the opportunity to purchase a specific number of shares of stock at a specified price during a particular time period. If the employee fails to purchase at the specified time, then the option to purchase at the grant price is lost.
Options are granted for a variety of reasons. Some are even granted by contract. Knowing and clarifying those reasons makes the difference between something being community property or separate property.
Qualified and Non-Qualified Stock Options
Incentive stock options can be either qualified or non-qualified. The tax ramifications on each are very different and a failure to recognize the tax implications for proper distribution in a divorce can result in a gross inequity of distribution.
Qualified or statutory incentive stock options, often called ISO’s, have a tax due only upon the sale of the stock. Depending on when the option was exercised and when the stock was sold, the tax basis and tax rates can differ.
The other type of stock options are non-qualified options or NQSQ’s. Depending on the ability to determine value, the taxing differs. When the stock is traded on an established market so that the value is easily discernable, then income tax is due at the time of the grant of the option. But, if the stock fails to meet that standard and the option is not transferable, then tax is not due until the option is exercised.
Purpose of Grant of Stock Option
If grants are given and exercised during the marriage, then the grant, now being stock because the option was exercised, will be distributed as part of the community assets in the divorce. The issues arise when a grant was given and not exercised or is granted post commencement of the divorce action.
Stock options can be granted because of past performance, they can be granted as an incentive for continued employment, they can be in lieu of higher pay, in lieu of bonuses or they can be granted for a combination of these reasons. The reason for the grant of a stock option can be determinative of whether or not it is held to be separate property.
Distribution of Stock Options in Arizona Divorce
Arizona, like many states, distributes property of the community resulting from the marriage that was acquired during the marriage. In general terms, property acquired after the marriage by either party is considered their respective separate property. But, property acquired after commencement of a divorce action that is the result of efforts put forth during the marriage is part of the community. If the stock option is not yet vested at the time of the commencement of the divorce action determination of whether it is community or separate property gets tricky and the reason for the grant becomes so vital.
Arizona generally treats stock options as they do pension plans, but that varies when the option has not vested at the time the divorce action is commenced. This issue was addressed by the Arizona Court of Appeals in Brebaugh v. Deane, 211 Ariz. 95. Brebaugh recognized that the purpose of the grant of the stock option was the key to determining what portion, if any, was separate property or part of the community. When the purpose is determined by the trial court to be a result of efforts during the marriage, a formula was established to determine what portion of the option was available for distribution as community property. The formula weighs more in favor of the community rather than separate property. But, when the option is determined to have been granted for future efforts, Brebaugh established a different formula to be applied which weighs in favor of separate property.
Brebaugh shows us that a contract setting forth the purpose of the grant is not necessarily sufficient to make the entire unvested option fall into the category set forth in the contract. Employment contracts could contain these provisions and there are often stock option contracts stating the purpose of the grant. The trial courts a granted a great deal of discretion in deciding the purpose of the grant of the option. Depending on the court’s decision on that question makes the determination on which formula to apply in each case. There is no cookie cutter result on classification of unvested stock options in divorce actions.